The Wolf Is Wall Street

The Big Bad Wolf always gets a bad rap. Because the real story is in those first two pigs – they had their fate coming to them. Don’t blame the wolf for doing what everyone knows a wolf does.

A wolf is a wolf, no matter what. If he’s dressed in sheep’s clothing or a Wall Street banker’s Saville Row best, you know what lurks within: a predator with a penchant for the tasty, squishy bits. And if you know a wolf is on the prowl in your neighborhood, you don’t prepare lightly for the very real possibility that your tasty, squishy bits are the bits he’s coming after.

Straw and sticks? Really?

Might as well just slap a sign in your front yard: Pulled pork here!

By which I mean today’s investors who believe the Trump Trade will keep on keeping on are tomorrow’s tasty, squishy bits for the wolf of Wall Street.

Valuations Gone Wild

Everything right now seems so … sedate.

Consumers are apparently in high cotton, if one is inclined to believe the sentiment-index measure, which is now back at levels last seen just prior to the Great Recession. Small-business optimism has spiked since late last year, and small-business owners are acting like it’s 2003 all over again.

Unemployment is down to 4.5%, the lowest in more than a decade (though, we won’t talk about the inconvenient truth that the bulk of the jobs America has created are low-wage service-sector jobs that do not support a middle class).

And, by golly, Mr. Market is proving all the cheerleaders right: He just won’t stop running higher. He stops to take a breather every now then, but let’s all praise Dow 50,000 because that’s where we’re going – right?

Then the wolf huffed and he puffed and he blew the house down … and he made tasty pulled pork sandwiches later that night for all his buddies in the pack.

Call me a curmudgeon. Call me a negative Nelly. Tell me I live on the dark side of life – that I only see a half-empty glass. That I should shut up and stop putting negative energy into the market. But facts are facts no matter how you dress them up, and the facts today are worrisome for those who buy into the malarkey that stocks can keep racing higher from here.

Outside of 2007, valuations are the most egregious they’ve ever been.

I use the Shiller P/E ratio to support that statement. Like every measure, Shiller has its flaws. But it’s a truer measure of valuation than a one-time snapshot based on trailing or expected earnings (particularly when Wall Street is usually too bullish on the future). All sorts of monkey business happens in a single year. And who can say the benefits and demerits a single year’s economy imposes on a market? Better to silence some of the noise with a 10-year, inflation-adjusted stream of earnings to calculate a more-honest P/E.

Here’s what we get…

Shiller P/E:

Oxygen Deprived & Primed to Plunge

Tell me – how safe do you feel at these levels? We’ve been at these levels precisely once before. That ended badly.

We were close to these levels nearly a century ago. That, too, ended badly.

Why should this time be any different?

It’s like we’re climbing Everest without the oxygen. And it’s icy.

And a storm is brewing on the horizon … in the form of corporate profit margins that are too far above historical norms and likely in for a comeuppance. Another chart serves our purpose…

Corporate Profits Margins:

Way Above Norms … and Dropping

From the depths of the Great Recession through the summer of 2012, corporate profit margins more than doubled to a historic peak of nearly 11% from 4.6%. Both of those are well away from the long-term trend line (we’re talking 70 years) that runs between the 6% and 7% range, which seems a fairly normal profit margin. Granted, companies are much more efficient today and technology has taken costs out of the system, but technology and efficiency have not permanently altered Economics 101, in which high profit margins always attract competition, or always result in labor battling for a greater share of the profits.

That is now occurring. Profits margins are back below 10% and are falling. Follow that through Wall Street and you begin the sense the problem at hand. Stock prices are a function of profits, and if profits fall, well we can count on one of three results:

Stock prices stay the same and the P/E ratio expands even more (since the “E” is suddenly smaller);

Stock prices fall (the “P”) so that the P/E ratio retreats toward normalcy;

Stock prices go nowhere for years so that the “E” can catch up with the “P” and bring the ratio back into line with norms.

I think I know which one of those is most likely – door #2.

I can’t say how much the stock market will retreat, only that it will retreat – and that the downside will almost assuredly overshoot fair value.

Our Profit Strategy: Three Protections

It’s not hard to figure out where to be right now with a meaningful slug of your portfolio: gold, intermediate-term U.S. Treasury paper and the Japanese yen. That last one will probably derail some readers; we’ll get it in a moment.

Gold and bonds are more obvious. They are the safety trade.

Gold has maintained it strength for the last several years – the smartest money in the world telling those who will listen that the price of insuring against a governmental, central banking or currency crisis is roughly $1,200 per ounce. Gold at this point is pure insurance. Not owing it is like buying a house and not insuring it in case of disaster.

Bonds, meanwhile, will rally when stocks downshift, despite Federal Reserve expectations of multiple rate hikes this year. Intermediate-term bonds, in particular, will win because the 2- to 5-year paper is where relatively decent yield resides, and that’s where the safe money will collect.

As for the yen, it’s oddly a safer haven than the dollar. It was the one notable asset to rise in value against the dollar as everything else crumbled during the Great Recession. The buck lost more than 47% of its value against the yen from summer of 2007 (just before the crisis began) to early 2012. (Another way of saying that is that the yen gained more than 60% on the dollar).

There are two key reasons for this:

The yen is a carry-trade funding currency, so when investors feel frisky, they sell negative-yield yen to buy higher-yield currencies so they can pocket as profit the interest-rate spread. When fear replaces the friskiness, the all dive back into the yen at once, driving up demand, which drives up the yen’s value against all the other currencies being sold – including the dollar.

Japan is the world’s largest creditor nation, so there are boatloads of yen floating around outside of Japan. Again, the minute fear erupts, that money rushes home again for reasons of safety – driving the yen higher relative to other currencies.

What I’ve recommended to the investment group to which I consult is to increase exposure to:

The yen through Guggenheim CurrencyShares Japanese Yen (FXY);

Gold through ETFS Physical Gold Shares (SGOL), which I like better than other gold ETFs because it owns physical, allocated gold rather than gold swaps and whatnot that other ETFs own and which, in a crisis that sees gold shares spike, will prove to be the downfall of many investors who thought they owned physical gold but really owned a bunch of paper;

Intermediate-term bonds through the Guggenheim Total Return Bond ETF (GTO).

I don’t get any benefit from mentioning these particular investments. They’re just the ones I like best because of what the own, their return profile, and the expenses.

We all know the wolf is coming. At this point, it’s just a matter of who built their portfolio with bricks, and who stuck to straw and sticks…

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About Author

Jeff Opdyke

Globally focused investment analyst who has traveled to more than 60 countries to put geo-political and geo-economic events into an investment perspective. I consult to asset- and wealth-management firm 1291 Group of the America. And, since my 9/11 experience, I worry that America is moving in the wrong direction...